Corporate credit spreads are ‘collapsing’

One of the most important yet overlooked stories in the Australian economy right now is the extraordinary compression in corporate credit spreads and bank funding costs.

But don’t expect to see banks cutting rates further than the RBA, or giving back margins they’ve previously internalised.

In the “new normal" where credit growth tracks incomes, and expands at less than half the rate experienced during the last two decades, banks are struggling to maintain their historical double-digit returns on equity.

The remarkable collapse in the cost of corporate debt over recent months, which has accelerated in the last few weeks, is one part of a fascinating puzzle that is superficially hard to reconcile with the Reserve Bank of Australia’s argument that the Australian economy needs extreme monetary stimulus.

If you question this latter comment, consider this claim in a CBA media release during the week: “the Bank’s three, four and five-year fixed-rate loans are at the lowest they’ve been for more than 22 years."

When the RBA effectively pre-committed to an October rate cut after its meeting on 4 September, the iron ore price had slumped more than 36 per cent in the preceding two months.

It just so happened that iron ore prices touched their 2012 low of US$86.7 on the day of the RBA’s September meeting. Every single journalist and commentator who managed to anticipate the RBA’s allegedly “surprise" decision to cut rates a few weeks later – and there were many – argued the bank wanted to relax policy on the basis of the precipitous decline in commodity, and particularly iron ore, prices (see my first chart).

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On September 5, The Sydney Morning Herald’s Peter Martin said, “The Reserve Bank is preparing to enter a renewed interest rate cutting cycle as signs the best of nation’s commodity boom is behind it … The bank is deeply concerned about what it calls ‘’sharp’’ falls in ‘’some commodity prices of importance to Australia. The iron ore spot price has slid near vertically from $US135 a tonne in July to about $US89 last night."

On 17 September, The Australian’s economics editor, David Uren, wrote “The Reserve Bank is almost certain to cut rates at its next meeting in response to … concern that the dollar was rising while key commodity prices fell, with the RBA seeing this as a tightening of financial conditions."

And in calling a cut the day before the RBA’s October meeting, Alan Mitchell opined “The drop in iron-ore and coal prices … is creating stresses as it works its way through the economy … the shock wave will spread."

A wrinkle for the central bank is that iron ore prices have now surged back 35 per cent to just under US$120. And this positive price action correlates with a range of other real-time financial market variables that imply investors are not buying the doom and gloom that is being used to justify pushing borrowing rates close to 40 year lows.

The Australian dollar, which is a key China and global growth proxy, has recently appreciated through 104 US¢, and is currently around its level prior to the RBA’s October cut.

Goldman Sachs’s China economist, Yu Song, told clients on Thursday that China’s third quarter GDP data showed “a genuine rebound" with quarter-on-quarter growth strengthening to “2.2 per cent (or an estimated 8.9 to 9.3 per cent annualised rate) from 2.0 per cent (8.0 to 8.5 per cent annualised) in the second quarter."

Domestically, the Australian sharemarket, including dividends, has soared 8.4 per cent in the last three months alone with the ASX 200 punching through 4,500 points.

And the cost of Australian corporate credit has been falling through the floor. In June this year, NAB issued over $1 billion worth of floating-rate bonds on the Australian Stock Exchange.

The issue margin was 2.75 percentage points (or 275 basis points) above the 90 day bank bill swap rate. Today the same bond can be purchased on the ASX for less than 200 basis points over. In addition to its running yield of 5.6 per cent per annum, early investors in the NAB bond have made absolute capital gains of about 3.7 percentage points in just four months.

Due to the European sovereign debt crisis, CBA was compelled to price the bond at a staggeringly high 175 basis points over the quarterly bank bill swap rate. Today the same bond can be acquired for just 65 basis points over. Investors in the issue have made raw capital gains of 4.5 percentage points above the current running yield of 3.7 per cent.

My second chart shows the daily trading margins from a sample of wholesale floating-rate bank bonds since November 2011. The trading margin is the spread at which these bonds price each day over the swap rate.

One gets a sense of the nature of the moves from daily summaries published by bank trading desks. A major bank trader said last Friday was “another strong day with plenty of buyers pushing majors [bonds] 2-4 [basis points] better and offshore banks 10-20 [basis points] better."

At the close of business on Tuesday, the same trader relayed: “Another monster move today with most bonds gapping tighter as the street decided to throw the towel and started aggressively lifting [buying] bonds." On Thursday he commented Aussie bond spreads were “literally collapsing now."

Steve Shoobert at CBA expects highly rated bank bonds to continue to perform well due in part to their scarcity value: “Overall bank issuance will be light in 2013 because lending growth is weak relative to deposit growth. We estimate that Australian banks’ net requirement for term funding remains negative and therefore anticipate bank’s overall bond issuance will fade in 2013."

Augusto Medeiros of Deutsche Bank argues that while Aussie bonds could realise further capital gains, this relies crucially on a diminution in global tail risks. “Major bank paper is fairly priced at the moment. Although fundamentals – or their rating – conceivably justify tighter spreads, pricing for the sector globally is still being affected by offshore macro uncertainties", Mr Medeiros says.

I believe we’ve moved through an important inflexion point in domestic savings and investment decisions. Rightly or wrongly, the RBA has decided to push savings rates below the threshold where investors feel they offer a fair return above the cost of living. This means the central bank is forcing individuals and institutions to search for higher yields elsewhere. This is in turn driving savings into alternative asset-classes, such as corporate bonds, hybrids, equities, and housing.